Sat, May 07, 2011 - Page 9 News List

The hunger for ethanol

The result of higher prices for corn could be a significant stimulus to economic growth in rural regions of developing countries — where most of the world’s poor live

by Wallace Tyner

Illustration: Lance Liu

Food prices have in many cases surpassed the peak levels reached in July 2008. At that time, food-price increases were attributed to growing global demand for food commodities, a major decline in the value of the US dollar, crop failures in some parts of the world and biofuels, but what is driving the surge in prices today?

I believe that the key factors now are somewhat different from those that drove up food prices in 2008. Growth in global demand for food and feed commodities is still a major part of the story, as are biofuels, but the short and long-term implications are quite different.

As developing countries become better off, one of the first things that happens is so-called “dietary transition.” With more income at their disposal, people begin to consume more of their food basket in the form of animal products. Producing these animal products requires significantly more agricultural resources than a predominantly plant-based diet. So, as incomes grow, demand for food products grows even faster. Both population growth and dietary transition contribute to faster demand growth and higher food prices.

Biofuels policies in the US and the EU have led to the creation of biofuels industries with significant output capacity — mainly ethanol in the US and biodiesel in the EU. In the US, government policy mandates 48 billion liters of ethanol this year. Production capacity already exceeds that level.

Since this quantity is required by the government to be blended with gasoline, regardless of the price of ethanol, corn or gasoline, the demand that it creates for corn is not at all responsive to the price of corn. In economic terms, such demand is highly “inelastic” — the mandate must be met at any price.

That is the situation in which we now find ourselves, at least in the short run. The added inflexibility (or inelasticity) amplifies the price response to a real or perceived crop shortfall, either in the US or elsewhere. In addition, the fact that nearly 40 percent of the US corn crop is being used for ethanol, up from about 5 percent a few years ago, means that corn prices must be higher to meet the feed, export and ethanol demands for corn.

The bottom line is that the current version of US biofuels policy, with its fixed requirement for blending, leads to a greater price response in the event of a crop shortfall — in the short run. We saw this in 2008 and are now seeing it again, but this year’s surge appears to be rooted in broader commodity scarcity than before. In the first half of 2008, commodity prices moved up quickly — and plummeted just as fast in the second half of the year. There may well have been speculative behavior that contributed to the rapid swing.

Even with normal crop production around the world, we will end this year with stocks-to-use ratios near historic lows. Stocks-to-use ratios are a primary driver of commodity prices, because they give us an indication of the cushion that we have for shortfalls somewhere in the world. The ratio tells us essentially how many months of stocks we have and today they are about 15 percent for some key commodities — meaning two months of stocks.

What about the long run? With several years to adjust, we would expect a powerful supply-side response to higher commodity prices now prevailing all over the world.

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